This document discusses various strategies for managing financial risk, including hedging with forwards, futures, and swaps contracts. It provides examples of how companies and individuals can use these derivatives to reduce currency risk, interest rate risk, and commodity price risk. It also discusses insurance and how pooling risk across many entities can help share the costs if a rare but expensive event occurs for one member.

1. Managing risk

13. Hedging with Forwards and Futures 1- Spot Contract - A contract for immediate sale & delivery of an asset. 2- Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future. 3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract. The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & “provides” a secondary market for the speculation of Futures.

14. Types of Futures Commodity Futures -Sugar -Corn -OJ -Wheat -Soy beans -Pork bellies Financial Futures -Tbills -Yen -GNMA -Stocks -Eurodollars Index Futures -S&P 500 -Value Line Index -Vanguard Index SUGAR

16. Futures and Spot Contracts The basic relationship between futures prices and spot prices for equity securities.

18. Futures and Spot Contracts The basic relationship between futures prices and spot prices for commodities.

20. Homemade Forward Rate Contracts

21. Swaps

36. Commodity Speculation Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160 Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290 Loss of 10.23 % = - 5,130 You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncured bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?

38. Commodity Speculation with margin You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncured bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss? Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160 Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290 Loss = - 5,130 Loss 5130 5130 Margin 50160 x.15 7524 ------------ = -------------------- = ------------ = 68% loss

39. Hedging

40. Exchange Rates March 22, 2004

47. Exchange Rate Relationships Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 6.7 % or a 1 year US bond (in dollars) @ 1.22%. The spot rate is 10.9815 peso:$1 The 1 year forward rate is 11.5775 peso:$1 Which bond will you prefer and why? Ignore transaction costs

48. Exchange Rate Relationships Value of US bond = $1,000,000 x 1.0122 = $1,012,200 Value of Mexican bond = $1,000,000 x 10.9815 = 10,981,500 peso exchange 10,981,500 peso x 1.067 = 11,717,261 peso bond pmt 11,717,261 peso / 11.5775 = $1,012,072 exchange Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 6.7 % or a 1 year US bond (in dollars) @ 1.22%. The spot rate is 10.9815 peso:$1 The 1 year forward rate is 11.5775 peso:$1 Which bond will you prefer and why? Ignore transaction costs

54. Forward Rate vs. Actual Spot Rate Percent error in the one month forward rate for Swiss Franc per US $ compared to actual spot rate

55. International Prices The Big Mac Index – The price of a Big Mac in different countries (May 29, 2004)

56. Purchasing Power & Exchange Rates Relative change in purchasing power, percent Relative change in exchange rate, percent

57. Exchange Rates Nominal versus Real Exchange Rates U.S. Dollar / British Pound (in log scale)

58. Interest Rates and Inflation Countries with the highest interest rates generally have the highest inflation rates. In this diagram each of the 129 points represents a different country. Average inflation rate, percent, latest 5 years to 2003 Average money market rate, percent, latest 5 years to 2003

59. Exchange Rate Risk Example - Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 120.700Y:$1 the car sells for $14,209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134Y:$1, what will be the price of the car? 1,715,000 = $12,799 134 Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.

60. Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of 120.700Y:$1, the motorcycle sells for 1,448,400 yen in Japan. If the dollar rises in value and the exchange rate is 134Y:$1, what will the motorcycle cost in Japan? $12,000 x 134 = 1,608,000 yen